Ben Bernanke Versus Ben Bernanke: Fed Chair Flip-Flops With QE2

11/15/2010 01:11 pm ET
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Updated
May 25, 2011

Robert Auerbach
Professor of Public Affairs, The University of Texas at Austin

The Bernanke Federal Reserve's recent plans to print more money, QE2 (Quantitative Easing 2), with the intention of stimulating demand to provide full employment without inflation is a policy in dismal company according to Ben Bernanke's own views before he became Fed chairman.

Bernanke and his coauthor, Professor Andrew Abel, told the students who read their 1992 Macroeconomics textbook about the modest money policy in the United States:

For example, in recent years the monetary base (currency plus reserves in the banking system) in the United States has typically increased about $10 billion per year, which is much less that 10% percent of the deficit and less than 1% of total government expenditures.

After referencing the modest monetary expansion in the United States at that time, Bernanke and Abel described a country that would have a "heavy reliance" on the printing press to finance a country's deficit:

Rather, a heavy reliance on siegnorage [the benefits to the government from printing money] usually occurs in a war-torn or developing countries, in which military or social conditions dictate levels of government spending well above what the country can raise in taxes or borrow from the public. (p. 673.)

The current spike in the U.S. monetary base that the Bernanke Fed created has more than doubled since August 2008 to a level around $2 trillion. Adding to the monetary base the QE2's $600 billion now being issued, the spike is off the Federal Reserve chart that goes back to 1959.

Bernanke and Abel emphasized printing press malpractice in their 1992 book when they discussed the very rapid inflation in 1922-23 in Germany:

When a country embarks on a path of printing money to cover deficits, two forces threaten to drive the process out of control. First, when the inflation becomes very high, the real value of tax revenues ... declines" ... leading to a higher rate of money creation ... that results in higher inflation. (p. 677)

Before you conclude that the Bernanke Fed's policy of "heavy reliance" on the printing press will turn the United States into a banana republic (with no bananas), as Bernanke and Abel have described, consider the very prestigious theoretical support for a "heavy reliance" on monetizing the country's deficit.

The brilliant English economist, John Maynard Keynes, enshrined this policy in his 1936 book, The General Theory. "If the deficit was financed by printing money", Keynes wrote, "that would also benefit the economy no matter how wasteful the method of distribution."

This Keynesian solution to recessions was heralded around the world by economists including Abba Lerner, a major force in introducing Keynesian theory into the United States when he moved here from England. He taught at Roosevelt University in Chicago, Michigan State University, the University of California at Berkeley and Florida State University. I was his student in a number of classes.

Lerner's genius and unconventional behavior made him somewhat of a cult figure. Arriving at an American Economics Association annual meeting in the 1960s at a major hotel in Washington D.C. he handed the doorman his luggage -- a shopping bag. He was given a special room at the hotel where he displayed his mobiles, all made out of wire hangers he had twisted. At one final examination he wrote two words on the blackboard, "interest rates,' and left the room.

Abba Lerner was a master logician who originated many economic theories that are still used in economics. He meticulously constructed geometric proofs that showed the association between many important concepts. He carefully used the concept of marginal changes (small changes) in variables when formulating theories.

His analysis of government deficit spending financed by the printing press was an exception to his devotion to the importance of marginal changes. Lerner, following Keynes, advocated government deficit spending to stimulate an economy in a recession, a policy Lerner called Functional Finance. His description of financing deficits by printing money in his 1951 book The Economics of Employment included a statement that supports the policy of the Bernanke Fed's QE2: "The stock of money needed for the convenient operation of a modern society is in any case so large that having a larger stock of money could not be much more dangerous." If I had not read his book, I would not have dared to write that statement on his test about interest rates.

Later when I transferred from the teachings of Abba Lerner to the teachings of Milton Friedman at the University of Chicago I became convinced that Abba had made a terrible mistake. "Heavy reliance" on running the printing press to finance government spending is not immune to serious consequences. There are substantial immediate effects as well as expectations of inflation and higher interest rates that may well appear over time.

Milton Friedman warned that once sustained inflation occurs there is only one way to stop it from getting worse. Slow down or stop the printing press and that will cause a recession.

The brilliant Paul Samuelson also introduced students and future economists around the world to Keynesian economics in his famous introductory textbook first published in 1948 (and still published in 2009 by Paul Samuelson and William Nordhaus). In the 1970s Samuelson invented the word "stagflation" for an economy with the twin conditions of inflation and unemployment. This condition was a correction for Keynesian models that incorrectly held that inflation only occurs when the government stimulates with deficit spending after full employment is reached. Stagflation could leave the Bernanke Federal Reserve's printing press policy intended to achieve full employment without inflation at a dead end with no viable way to back out without further injuring its objectives.

Despite the long debate over Keynesian policy and limited government, that still lasts after both have died, Paul Samuelson and Milton Friedman both would likely agree with Ben Bernanke's 1992 description of the dismal circumstances of countries that place "heavy reliance" on printing money to finance their deficits. Both would also agree that there is a short run stimulus from "heavy reliance" on money creation.

Today, with huge international financial markets, instant communication and flash trading in financial assets, the reaction time to new expectations is very rapid and could overcome the stimulus. The negative effects of expectations that countries may adopt policies to offset a perceived managed debasement of the U.S. dollar from QE2 can quickly arise. The expectations of longer term effects on inflation and interest rates can also reduce U. S. business owners' incentive to hire additional employees. Interest rate increases will dramatically increase the interest rate the government would have to pay to finance the trillions of dollars of debt that will have to be rolled over to keep it afloat.

The stimulative effects of QE2 may be small and the costs may be large. One of these costs will be the payment of billions of dollars by taxpayers to the banks which currently hold over 50 percent of the monetary base, over $1 trillion in reserves. The interest payments are an incentive for banks to hold reserves rather than make business loans. If market interest rates rise, the Federal Reserve may be required to increase these interest payments to prevent the huge amount of bank reserves from flooding the economy. They should follow a different policy that benefits taxpayers and increases the incentive of banks to make business loans as I have previously suggested.